Are you eligible for the 20% Qualified Business Income Deduction?
Oftentimes, taxpayers choose to own their real estate and operating company in two separate entities for a multitude of reasons. They then rent the real estate to their operating company and charge rent which is reported on their personal return. The operating company would report rent expense on their business return.
With the passage of the new tax law called Tax Cuts and Jobs Act (TCJA) in December of 2017, a new question arose: does the income generated on the rental qualify for the 20% pass through deduction? As with most answers to tax questions, the answer is “It depends.” The first test that must be met is the operating company has to be a trade or business under a specific code section of the Internal Revenue Code. Basically, the activity has to be regular and continuous and have a profit motive. Most operating companies would pass this test with no problem.
The next test that must be met deals with how the operating company is taxed. If it is a partnership (Form 1065) or an S-corporation (Form 1120), then the self-rental takes on the character of the business. For example, if the operating company is a brokerage firm who rents a building from the owners, the rental is considered a brokerage company. This means the self-rental is eligible for the 20% pass through deduction subject to the various phase-outs and taxable income limitations.
What happens if it’s a self-rental to a C corporation (Form 1120)? For this circumstance, the rental does not take on the character of the business and is looked at as a standalone business. We then must determine whether the rental is a qualifying trade or business. Most self-rentals are set up as triple net leases. A triple net lease is an arrangement that requires the tenant to pay real estate taxes, fees, building insurance, and maintenance costs. The IRS has categorized a rental with a triple net lease as an investment rather than a business. Because of this, the income would not qualify for the 20% pass- through deduction. However, there are always unique circumstances where it could qualify.
The self-rental rules surrounding the 20% pass-through deduction are mostly straight forward, but there are nuances to the rule that must be considered. If you have a self-rental and are unsure of whether it qualifies for the 20% deduction, please talk to your CPA or tax professional.
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